Oil revenues depend on the market price
at the time the oil is sold so when the price is high, oil revenues
are high, and when the price is low, oil revenues are low. Since it
is impossible to know in advance what the future price of oil will be,
oil revenues are inherently volatile. This makes state fiscal planning
difficult because the state must maintain some type of "cushion"
to compensate for when oil revenues are lower than average, and also
must resist the temptation to spend everything when oil revenues are
higher than average.

Hedging is one way to reduce the volatility
of future oil revenues. Various hedging mechanisms could guarantee
a future price for our oil. The Department of Revenue analyzed this
method for reducing revenue volatility in 2002, and came to the conclusion
that it is was not a good idea. Hedging costs money and carries political
risks. In addition the Constitutional Budget Reserves already serves
as a mechanism to minimize uncertainty in the budget process. Their
analysis appears at the end of this section.

There is another argument sometimes made
in favor of hedging. This is the idea that by hedging the state would
be able to increase the total amount of future oil revenues. It
would do this through mechanisms such as futures contracts which
would guarantee that we would be able to sell our oil in the future
at a higher price than the market price when the oil is produced.

Although this sounds like an easy way to
increase oil revenues, particularly when the price of oil reflected
in futures contracts is high, it would not work.

The idea that we can somehow take advantage
of today's high prices (reflected in future markets) to assure ourselves
of a high price for our oil from now until the end of time is bogus.
If this were possible the oil industry would be doing it themselves
but they are not.

Increasing oil revenues through hedging
would require the state to consistently "beat the market"--basically
like gambling. State bureaucrats might be able to do this for a while,
but over time one would expect their guesses about future price to be
too high about half the time and too low about half the time. In the
long run one would not expect them to do any better through hedging
than by accepting the market price.

In order for the state to come out ahead
in the long run, there would have to be someone willing to offer the
state a price guaraentee who would consistently lose money. In order
hedge, there must be someone willing to accept the responsibility to
pay the higher than market price.

Who would willingly and continuously take
a loss by agreeing to buy 1 million barrels of oil per day at a price
higher than they would be able to sell it in the market? No one.

* * * * * * * * * * * * * *

Oil Hedging (Alaska
Department of Revenue, Fall 2002)

INTRODUCTION AND OVERVIEW From
Alaska's perspective, locking in a predictable price for oil, even if
it means giving up the opportunity to make more money if prices are
higher than expected, is called trading in futures, or simply "hedging."
Hedging essentially comes in two flavors: 1. Selling oil in advance
to lock in a price and, in exchange, giving up the opportunity to make
more money if prices rise (e.g., hedging with futures). 2. Paying a
premium to ensure a minimum future price, while also retaining the opportunity
to make more money if prices rise (e.g., hedging with options). Because
of the upside benefits, this is more costly than hedging with futures.
Alaska has not yet needed to pay the costs or take the risks of hedging
its future oil revenues because our cushion against fluctuating oil
prices for the past decade has been the Constitutional Budget Reserve
Fund (CBRF). The fund was established a decade ago for exactly that
purpose to fill the gap between a fluctuating revenue source and a constant
need for public services. The Budget Reserve Fund is a marvelous tool
when used properly. We have strayed, however, from its original intent.
Instead of simply covering temporary revenue shortages as oil prices
move up and down each year, we've been draining the account to cover
a structural gap in Alaska's finances. As North Slope oil production
declines, taking state revenues down with it, we're spending more than
we take in each year and we're relying solely on the CBRF to fill that
gap. Similar to an oil field, the Budget Reserve Fund is a non-renewable
resource. The large oil and gas tax and royalty cases that filled the
fund over the past decade have all been settled. Considering how important
the CBRF is to Alaska's fiscal health, and how it can allow us to survive
low oil prices, it would be irresponsible to empty the CBRF. But unless
we do something soon, that is what will happen. A hedging program, however,
could allow the state to know with more certainty when the CBRF will
hit empty. By starting a hedging program immediately, the state could
lock in some of its oil revenues for the next few years. This would
provide the public and elected officials with a somewhat more predictable
timetable for draining the CBRF. We would know much of our revenues
each year and how much we would need to withdraw from the fund. The
outcome would be essentially the same, only without the uncertainty
of when. We do not recommend this option since we believe the certainty
of knowing when the CBRF will run out isn't worth the cost.

HOW WOULD HEDGING WORK? The Department
of Revenue expects that receipts from oil royalties and production taxes
will provide two thirds of the state's unrestricted general purpose
revenue for the next five years. These revenue sources depend directly
on the price of oil. For each $1 per barrel change in the price of oil,
the state's annual royalty and production tax revenue will rise or fall
by $65 million. The question is how to protect those revenues and the
public services they pay for from falling oil prices. Active oil futures
and options markets provide the state an opportunity, during periods
of high oil prices, to put a floor under or a range around that is to
hedge its anticipated royalty and production tax revenue. Because these
markets anticipate oil prices to remain above the historical average
for the next two or three years, the state could take advantage and
for a price secure a more stable revenue stream for the next few years.
There are two primary instruments used to hedge: futures and options.
Futures contracts provide for the future delivery of oil at a specified
price. Any profit or loss from the agreed upon price vs. the actual
market price on the delivery date is usually settled on the delivery
date. For example, in mid April 2001, the state could have contracted
to sell West Texas Intermediate oil at $23 a barrel for delivery in
December 2003 (there is no futures market for Alaska North Slope crude).
If the market price is below $23 a barrel in December 2003, the state
would still receive its $23 because the buyer of the futures contract
would pay the state the difference between the market price and $23.
But if the price goes up and WTI is worth $25 a barrel in December 2003,
the state would have to pay the difference between the market price
and the $23 in its futures contract. Of course, if prices are up, the
state could use its higher revenues to pay the bill. In summary, the
state would be protected if prices fall but could lose out on extra
revenue if prices rise. And while the up front cost for a futures contract
is minimal, the state could be faced with a significant liability if
prices rise above the contract price. Options are more like insurance
policies, with an up-front premium. For a per-barrel fee paid in advance,
an options contract gives the party on one side of the contract the
opportunity but not the obligation to buy or sell oil to the other party
at a prearranged price. For example, the state could pay the up-front
options premium to sell WTI at $23 a barrel in December 2003, locking
in that price. This would be buying an option to sell oil-called a "put"
in the trade jargon. If the price is below $23 in December 2003, the
state would exercise its option and the party that sold the put would
have to make good to the state on the difference between the market
price and $23 a barrel. And if the price in December 2003 is above $23,
the state would gain the additional royalty and production tax revenue
from the higher price. In summary, the state is guaranteed at least
$23 a barrel either way, but that guarantee would come at the high up-front
cost of the options contract. The up-front cost of buying put options
is substantial, although there would be no downside risk or additional
costs at the end of the contract.

WHY WOULD THE STATE WANT TO HEDGE?
First, the volatility in state revenue could be reduced. Second, with
a realistic long-range fiscal plan in place, the state could help ensure
its ability to meet its public service obligations during short periods
of low oil prices if it no longer had the CBRF to serve as a cushion.
Hedging is not expected to increase royalty and production tax revenue
over the long term but, at some cost, it can increase the year to year
consistency of royalty and production tax revenue to the state. Most
hedging is done to remove or reduce the uncertainty associated with
a volatile revenue stream. The question becomes whether we are willing
to pay that price to gain the benefits of hedging. That is, would the
benefits of knowing how long the CBRF will last be worth the cost? We
do not believe it would.

REASONS NOT TO HEDGE There are
several reasons why state officials might be reluctant to initiate a
hedging program. First, the state already has a means for paying for
vital public services when oil prices are low the CBRF. But if the state
continues its current fiscal habits, the CBRF will not last forever.
When it is exhausted, the state will be forced to significantly restructure
its public finances. Because oil prices are so volatile, using the CBRF
as the state's insurance against low oil prices makes it impossible
to precisely forecast when the CBRF will be exhausted. Second, a hedging
program would cost money. When considered alone, the transaction costs
for entering into futures contracts seem reasonable; they would cost
something on the order of $0.10 per barrel for each barrel of WTI futures
sold. To hedge all the state's royalty and production tax revenue using
futures would require contracts to sell 180,000 barrels per day (5.4
million barrels per month) of WTI futures. At $0.10 per barrel, a three
year futures program of this magnitude could cost $18 million to $20
million in up front transaction fees. But, if during a three year hedging
program based on futures contracts, WTI futures prices increased significantly,
the state would be required to fund a margin requirement that is, pay
up to cover the higher price. Remember, in a futures contract, the state
would be guaranteed a minimum price but would owe anything over that
price to the contract's buyer. If, for example, WTI futures prices on
average increased by $5 per barrel, the increased margin requirement
for such a price change on a three year futures contract would be over
$950 million. If oil prices actually stayed that high for the three
year period, the state would recoup that amount through higher than
anticipated oil revenue. Then, if the price of oil dropped back to the
hedged price, the margin required would be reduced and the state's payment
returned. If the state entered into a futures based program, it would
need to be able to come up with sums of money of this magnitude or larger
on relatively short notice. The per barrel, up front costs of an options
based program would vary widely. For example, a $0.75 per barrel fee
would put a floor under near term prices at a level about $1.00 per
barrel under the futures prices for the upcoming month only. However,
it wouldn't do the state that much good to lock in an oil price for
just one month ahead. Like all insurance, the longer the protection
you buy, the greater the cost. An option similar to the one above, covering
a one month period three years from now would cost close to $3.00 a
barrel. An options based hedging program covering three years would
cost something like $300 million. While the up front cost would be more
than a hedging program using futures, an options based program would
allow the state to retain any additional revenue if oil prices move
higher than the hedged level. Finally, some policy makers will be reluctant
to take the political risks of a hedging program. If a program succeeded,
it is unlikely the policy makers who took the initiative to create the
program would be rewarded with public congratulations. On the other
hand, if prices increased significantly and the state had sacrificed
that upside to reduce or eliminate the volatility in its royalty and
production tax revenue, the conventional wisdom is that public criticism
would be harsh.

LEGISLATIVE AND CONSTITUTIONAL ISSUES
Before the state could initiate an oil revenue hedging program, the
legislature would have to pass a law that authorized and spelled out
the program's parameters. Two states currently have oil revenue hedging
programs on the books, although neither state does any hedging: Texas
and Louisiana. Some aspects of a hedging program clearly would require
specific appropriations. For example, if Alaska embarked upon a program
that involved the purchase of options, it would need appropriated funds
to purchase the options. We are not certain which elements of a futures
based options program would require appropriations; certainly appropriations
would be necessary for any fees or commissions associated with the program.
If the state were required to put up large amounts from time to time
to cover margin requirements in a futures based program and on occasion
that could be hundreds of millions of dollars it is not clear if appropriations
would be required. The same issue arises with respect to payments required
when closing out futures contracts. The uncertainty about the need for
appropriations for a futures-based program also raises questions about
the constitutional prohibition of dedicated funds. Would contractual
commitments to cover margin requirements or to close out contracts two
or more years in the future violate that prohibition? We have discussed
the appropriations question and the constitutional issue with the Department
of Law, and they are not now prepared to provide definitive answers.

DEPARTMENT OF REVENUE RECOMMENDATIONS
The department recommends against initiating a hedging program if the
CBRF balance is expected to remain sufficient. There is no need to pay
for a hedging program when an adequately funded CBRF does the same job.
If it becomes apparent that state policy makers intend to spend substantially
all of the CBRF before they restructure the state's finances eliminating
our self insurance fund against low oil prices then we believe a state
oil revenue hedging program may become necessary. However, even that
will only work if the state has a long term fiscal plan to balance the
budget in years of average oil prices. To ensure the success of such
a hedging program, the state should initiate the program at least two
years (and preferably three years) before it exhausts the CBRF. The
principal benefit of an oil revenue hedging program would be to significantly
reduce fluctuations in the state's year to year oil royalty and production
tax revenue. With this reduction in revenue volatility, policy makers
would know more closely when the state would exhaust its CBRF and how
large the subsequent year to year revenue gap is likely to be. Would
these benefits be worth the costs of a hedging program? Our judgment
is that they would not, but it is just that a judgment call. Reasonable,
prudent decision makers could easily conclude that the benefits of instituting
such a program is worth the cost.

SUMMARY AND CONCLUSIONS Businesses
and investors hedge to reduce volatility. The markets that make hedging
possible also accommodate speculators who use the same instruments in
an effort to make money. Some of these speculators make money but many
do not. Business and entities like the State of Alaska should not hedge
to make money. Rather, policy makers should only look upon hedging as
a post CBRF option to stabilize the state budget and, by implication,
the state economy. Right now, the state manages oil price volatility
by relying upon the Constitutional Budget Reserve Fund to provide a
buffer between a volatile revenue stream and a stable expenditure budget.
The CBRF has worked extremely well so far to smooth out the bumpy path
of oil prices. And unlike a hedging program that will likely cost money,
the CBRF does not cost the state anything. In fact, the CBRF actually
makes money. If we keep $2 billion in the fund, we can expect to earn
$100 million or more annually. We would be foolish to not preserve the
CBRF for the long run as our best insurance policy against sudden economic
shock caused by low oil prices. However, if the state is going to exhaust
the CBRF prior to implementing a long term fiscal plan, and especially
if use of the earnings reserve of the Permanent Fund is restricted by
the proposed constitutional amendment, hedging is something the state
should consider.